Tail risk

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Risk management - treasury - rare events - financial markets.

Tail risk is the risk of adverse consequences from a 'tail event'.

Tail risk is often known as fat-tail risk.


This name comes from financial markets outturns tending to have 'fat tails', meaning both the likelihood and the size of potential losses and other adverse consequences are systematically underestimated.


This underestimation comes about from two modelling assumptions that are almost always wrong.

These wrong assumptions are:

(1) Potential future events are normally distributed, in a neat curve.
(2) The spread of the potential future events can be forecast with confidence by reviewing past events.


The underestimation of the likelihood and the size of the events leads to inadequate risk management responses to address the adverse consequences.


There is a refinement to the normal distribution assumption known as a lognormal distribution.

However, this does not address the fat tail problem.


Fat tail risk is also sometimes known as "black swan" risk.


Have a little more liquidity than most of your peers
"Corporates spend most of their time focused on the likely risks they face and the effectiveness of their controls to mitigate these to acceptable levels.
While this is essential, it’s also important not to lose sight of tail risk (often referred to as “black swan” risk) and to scenario plan how these risks might play out.
To illustrate, I’ll summarise two notable events that come to mind from my career in treasury.


As a corporate treasurer during the Global Financial Crisis (2007/8) I recall having very significant credit exposure on the Royal Bank of Scotland (RBS)/Natwest/ABN group.
The night before RBS was bailed out, I recall briefing my CFO on the position, explaining both the scale of our exposure, but also that the systemic nature of the risk meant it was highly likely to result in government intervention.
After a restless night, the UK Government announced the next day it was indeed stepping into support RBS.
In contrast, there were several other smaller financial institutions - always paying good rates - that failed, with their depositors suffering total credit loss.


In October 2022, as chair of the 100 Group pensions committee during the UK gilt crisis we saw a significant increase in gilt rates following the well documented Liz Truss budget.
Rates rose quickly requiring pension schemes to post significant collateral against their interest rate hedge positions, with somewhat of a self fulfilling impact, as many needed to sell gilts (their most readily realisable asset) to post cash collateral.
After much discussion with market participants, including the 100 Group pensions committee, the Bank of England stepped in to stabilise the market and provide liquidity support as the risk became systemic.
Generally 100 Group members came through unscathed. However many smaller schemes without robust liquidity positions had to close positions as rates headed up, and then suffered capital losses as rates came back down again when they were no longer hedged.


Afterwards, there was much debate in the pension industry about what was the right amount of liquidity, with large schemes all having a similar level (and generally better than smaller schemes) based on advisor Monte Carlo analysis of historical rates performance.
My advice is to have just a little bit more liquidity than the majority of others.
That way you are on the right side of the systemic risk intervention.


So the most important consideration on tail risk - is not crunching lots of detailed analysis - but rather to supplement this by stepping back and thinking through how things might play out."


Phil Aspin FCT, FTSE100 CFO, Chair of 100 Group Pensions Committee and former Group Treasurer.


See also

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